March Credit Update

Monthly Commentary

The risk asset rally came to a halt in March as the House’s failure to pass AHCA put a damper on the whole growth/reflation trade. Optimism over fiscal stimulus has waned as the ability to get tax reform and infrastructure spending done are now in question. Additionally, commodity price weakness caused some spread volatility, particularly in the energy and metals sectors. Other noteworthy events that occurred in March – though with little impact on credit spreads - were the Fed rate hike on the 15th ( third hike of the cycle) and the U.K.’s triggering of Article 50 of the Lisbon Treaty. Article 50 starts the legal process for the U.K/EU divorce, during which time issues such as trade and immigration are negotiated. The markets seemed unfettered by the looming Brexit and we saw no underperformance by UK credits/issuers. Investment grade supply totaled $129 bln in March, bringing the year to date total to $400 bln – that’s up 11% from last year. While the market did experience bouts of weakness due to supply indigestion and a subsequent increase in dealer inventories, demand has generally been strong as foreign and domestic inflows have accelerated. Dollar cost funding for foreign investors has declined over the past few months, making U.S. corporates marginally more attractive as hedging costs have improved.

YTD Fund Flows Summary: Inflows Have Been Strong

Source: BofA Merrill Lynch Global Research, EPFR Global

Fixed Income Mutual Fund Flows and HG Mutual Fund Flows

Source: BofA Merrill Lynch

Hedging Costs Have Come Down About 20 bps Since Year End

Source: BofA Merrill Lynch

Dealer Inventories by Maturity Bucket.
Inventories Have Increased Across All Maturity Buckets

Source: Wells Fargo Securities

Index Performance: Credit spreads as a whole were surprisingly resilient in March, with the index only 2 bp wider (OAS +112) despite the
AHCA debacle, elevated IG supply and triggering of Article 50. Spreads did exhibit some volatility intra month, touching the YTD tights of
+106 on March 6, then widening back out to end the month at a spread of +112 basis points over Treasuries. Of the five broad sectors,
utilities fared the worst, widening 4 basis points in March. The underperformance can be attributed to two factors: First, Southern Co and
Scana Corp spreads were negatively impacted after Westinghouse Electric filed for bankruptcy. The energy construction company owned
by Toshiba suffered massive delays and billions of dollars of cost overruns on its two nuclear plant projects – V.C. Summer (majorityowned
by Scana) and Vogtle (majority-owned by Southern). The completion of both projects appears to be in jeopardy as the path
forward remains unclear. There are some financial guarantees from the parent (Toshiba) that could offset some of the costs of moving
the project forward, however those details will likely be negotiated and take time to play out. Southern Co is the second largest issuer in
the utility index and spreads widened 17 basis points in March. Scana spreads were 29 basis points wider. The other factor negatively
impacting utility spreads in March was the index change. The minimum amount outstanding in the US Agg increased from $250 mln to
$300 mln effective March 31. This change had a disproportionately negative impact on both the utility and muni sectors. Approximately
213 securities/$58 bln market value of utility debt fell out of the index – that equates to about 15% of the utility index. That resulted in
5-10 bps of widening for now non-index issues as we saw some forced selling (indexers) as well as an increase in liquidity premiums
for those issues. The taxable muni index was also impacted by the removal of ~ 23% of the eligible universe. There was a quality bias in
the pool of securities that dropped out of the index as the average OAS for those securities was +122 bps vs. +151 for the non-affected
securities – a net OAS impact of 7 bps. Other sectors to underperform included metals (+11 bps), energy (+8) and autos (+6 bps). Autos
widened on concerns over falling used car prices and sales that appear to have peaked. Energy and metals widened on the heels of
commodity price weakness – though to put things in perspective, energy and metals spreads are still trade at 2.5 year tights.

March Credit Index Returns

Source: Bloomberg Barclays
*Muni and utilities issuers were most affected by index changes in March

Q4 Credit Fundamentals: Credit metrics for the non-fin IG universe stabilized somewhat in Q416 as EBITDA growth for the IG universe
(measured as LTM Q416 vs. LTM Q415) moderated to -1.6%. Excluding commodities, EBITDA grew modestly at 1.3% ( LTM Q416). Net
leverage increased .15x in Q416 to 2.25x, down from the peak of 2.32x in Q316. Since the cycle trough in 2011, net leverage has increased
.75x as cheap money has encouraged companies to spend more than they earn, issuing record amounts of debt aimed at benefiting
equity holders – via share buybacks, dividends and M&A.

EBITDA Growth -1.6%, x- Commodities +1.3%

Net Leverage down .07x Q-o-Q, up .15x Y-o-Y

Energy, Chems and Autos Saw the Biggest Increases
in Leverage. Biggest Declines in Leverage Came
from Metals and Mining.

Source: JP Morgan

March IG Supply: Supply totaled $129 billion in March, bringing the YTD total to $400 bln – up 11% year-over-year. Supply related
to M&A was ~ $14 bln in March including deals from Siemens ($7.5 bln deal to fund Mentor acquisition) and Rockwell Collins
$4.65 bln to fund B/E Aerospace acquisition). YTD M&A driven issuance is down significantly from the record levels of 2016, though we
may see an increase as there are still several pending M&A transactions that await regulatory approval, including the proposed $80 bln
AT&T acquisition of TWX. With the exception of a few issuers, new issue concessions were generally negligible despite their lackluster
performance. The largest deal of the month came from Verizon, issuing $11 bln in bonds across 4 maturities (10yrs priced at +160,
30yrs at +230). Part of the proceeds were used to tender some high coupon debt as well as fund the Yahoo acquisition and make
pension contributions.